Meta Platforms Emerges as a Promising Choice Amid AI Evolution

This year has undoubtedly belonged to the pack of stocks referred to as the Magnificent Seven. Till early June, which was when the YTD rally in the US markets started getting broader, this group alone had accounted for over 80 per cent of the upside in the Nasdaq 100 index (up 33 per cent till then). The seven stocks – Apple, Amazon, Alphabet, Microsoft. Meta Platforms, Nvidia and Tesla — are expected to dominate and benefit from the Generative AI wave in the current decade.

Their advanced investments in technology, vast talent pool, access to troves of consumer data and huge cash pile/annual free cash flows position them strongly in this space to tap the business opportunities whenever it gains scale over the next few years.

Of course, one company in the group — Nvidia — is already raking in the Generative AI moolah with its AI chips  accounting for more than 50 per cent of revenue. For the other companies, Generative AI is largely in the form of potential energy, while the kinetic energy is still in the form of their respective decades-old core businesses. However, the potential energy is significant enough to start factoring into the investment case. This is what the markets have given credit for this year, although it may have got stretched in some of the cases.

Based on risk-reward, Meta Platforms, which is the second best performing Magnificent Seven stock for the year after Nvidia, merits attention now. Since our previous buy recommendation in bl.portfolio edition dated November 6, 2022, the stock is up by a whopping 210 per cent in less than a year. Post this upside the stock currently trades at one-year forward EV/EBITDA of 9 times and PE of 17.5 times (Bloomberg consensus estimates). These are not expensive multiples for what is one of the most dominant technology companies in the world with a strong footing in the AI space.

Hence, investors who bought on our recommendation can continue to hold the stock as long as their investment horizon remains long-term. For new investors, we recommend accumulating on dips of around 10 per cent or more. The opportunities may come as a hawkish US Fed, concerns of an economic slowdown and spiking US bond yields increase market volatility.

How the tide changed

Last November it was all doom and gloom in the investment community when it came to Meta Platforms. The stock price had slipped to double digits (from a peak of $384 in 2021), levels last seen in 2015, as it faced a flurry of downgrades post release of Sep Q 2022 results. The fear psychosis stemmed from the company relentlessly continuing to invest in its unremunerative, cash-bleeding metaverse business (Reality Labs segment) and aggressive investments in AI, for which the payoffs were not clear. This had resulted in operating margins cratering to 20 per cent from 36 per cent in Sep Q 2021.

However, in our view, the correction represented one of the best investment opportunities in a high-quality technology company for five reasons – One, continuing solid trends in core business (Facebook, Instagram, WhatsApp, Facebook Messenger) and aps like WhatsApp still significantly under-monetised; Two,  financials expected to turn around, as part of the impact was also due to macro slowdown and Apple privacy policies impacting ad targeting for customers using Meta Platform products in its device (for which Meta was investing in workarounds). Meta had also clearly communicated an intent to curtail metaverse investments to ensure operating income growth in CY 2023; Three,  its dominant position in global digital advertising; Four, strong balance sheet and free cash flows which many a time provide downside support for stocks and Five, upside potential from its Reality Labs investments in the long term.

Since then the company embarked on an aggressive ‘year of efficiency’ in 2023 as it took steps to optimise its operations. These cost reduction initiatives, combined with turnaround in advertising revenues and company overcoming the impact of Apple’s privacy restrictions, have contributed to significant improvement in financials. One interesting thing to note is that the turnaround was made possible  by Meta’s investments in AI. Its AI-powered discovery engine has played a crucial role in driving engagement in its apps and its AI-powered automated marketing tools have helped to overcome the kind of encumbrances created by companies like Apple. For example, the company last year launched a marketing tool called Advantage+ that is powered by artificial intelligence and generates advertisements according to specific objectives of the marketer.

Beyond these, Meta’s launch of Twitter or X rival ‘Threads’ has also boosted sentiment around the stock. However, challenging the well-established network effect of X can be very difficult.

In recently reported June Q, both operating as well as financial metrics were strong. Across its family of apps, MAU and DAUs increased by 6 and 7 per cent respectively Y-o-Y. Revenue was at $32 billion (up 11 per cent Y-o-Y) and operating income was at $9.32 billion (12 per cent). Operating margin was at 29.4 per cent (significant improvement versus 20 per cent in 3Q 22 which spooked investors).

For CY23, operating margin is expected at around 30 per cent and to move above 35 per cent in CY24. This will reflect a significant turnaround for the company from its nadir last year.

Overall, most of the five reasons to own the stock still remain, except that the valuation is higher than when we gave our call in November 2022. At that time the company was trading at one-year forward PE of 8.6 and EV/EBITDA of 4.3.

Risk versus reward

The risks we see are economic slowdown and recession in developed markets that can result in current estimates getting lowered. Hence at current levels we prefer an accumulate on dips.

The long-term outlook has only got strengthened with emergence of Generative AI theme. Meta’s investments in AI will provide valuable intellectual property and expertise to tap the opportunities that mushroom out of the AI theme. Further possibility of metaverse investments paying off in the long run is also a prospect to be factored although nothing material is likely in the near term.